Friday, December 31, 2010

MACRO/INVESTMENT THEMES FOR 2011

INVESTING IN A STRUCTURALLY UNBALANCED WORLD

by Peter T Treadway, PhD

1. US Net Exports Have to Pick Up — Since 1992 the US has been registering ever larger current account and net export deficits.(Net exports are the major item in the current account.) At the same time other so-called developing countries, notably China in recent years, have registered massive current account and net export surpluses. This trend was only partially reversed by the cyclical fall off in US imports during the Great Recession in 2008. These massive current account and trade deficits have to be financed and this financing has resulted in equally massive dollar reserve holdings by China and other so—called developing countries. They also are also consistent with the view that American manufacturing jobs have suffered from this process.

Simple economic theory would suggest that capital intensive developed countries like the United States run current account surpluses with the relatively less capital intensive developing world. Developing labor intensive countries like China would run current account deficits. Admittedly this simple picture is complicated by the role the dollar plays as the world’s international currency. The United States needs to provide dollars to the world (something it has done with unbridled enthusiasm.)

Still on a structural basis one would expect that this trend of large US current account and net export deficits cannot go on forever. One might expect that the economic signals—including a cheaper dollar against the countries of East Asia– would favor US exports. My forecast would be that US companies that have an international scope and are able to access capital will fare relatively well in the coming years (assuming no major global recession). Moreover US has an expertise in technology. Approaching this from a macro top down perspective, I would conclude that larger companies with comfortable cash positions, global brand names and preferably technology niches would be well positioned as this necessary structural change in the global economic order unfolds.

2. Buy Gold, Sell Treasuries — The international monetary and domestic banking systems will continue to provide an inflationary global bias. In issue after issue of The Dismal Optimist I have argued that the global and domestic financial systems are inherently inflationary and dysfunctional and lack automatic mechanisms to correct imbalances. Thus China can hold down the value of the renmimbi by buying dollars thereby inflating Chinese high powered money supply, increasing Chinese holdings of US dollar assets and lowering US interest rates. Thus the Federal Reserve can get away with reckless printing of US high powered money, aka QEII, and finance the burgeoning US government debt.

Several respected economists, notably Gary Shilling, have argued persuasively that the US will be in a real estate driven debt deflation for the next several years and that long term Treasuries are a good investment. I might agree with this if the United States operated in isolation. But I think the global picture is inflationary thanks to the dysfunctional international monetary system and the army of money printing and currency manipulating central banks around the world. Inflation will creep into the US from abroad even as painful debt deflation continues to affect the domestic consumer. The worst of all worlds.

One can argue about the real factors affecting global inflation and their effects on commodity prices. One can argue that continued technology driven productivity enhancements combined with the addition to the global economy of giant labor pools from countries like India and China will provide what Shilling calls “good deflation.” Offsetting that is the view that all these new Indian and Chinese consumers will add to global demand on agricultural, energy and industrial commodities and thereby provide an inflationary commodity price bias. I tend towards the later view although a Chinese hard landing in 2011 could cut global demand and temporarily slow down the commodity story especially in the non-agricultural area. But either way, the massive increases in global money supplies thanks to our dysfunctional international monetary system are going to push commodity prices up.

I continue to believe gold should be in the typical investor’s portfolio. Fiat money is not trustworthy as the inflationary record of the US shows. For example, what you could buy for $1.00 in 1914—the year the Federal Reserve began operations and the gold standard was by and large abandoned – would cost $21.16 in 2009. What you could buy for $1.00 in 1871—the year financial historians assign to the advent of a universally accepted gold standard – would have cost $.84 in 1914. (If you want to play with these numbers yourself, check out http://www.westegg.com/inflation/).

I also think nominal interest rates globally will trend up in 2011 in response to the global monetary inflation and disastrous US fiscal situation. The market’s response to QE2 has been higher long term US Treasury interest rates. The world has started to mistrust the US government and its debt. The alternative explanation, paraded endlessly in the financial media, that long rates have risen because QE2 was going to be so successful in stimulating the economy , belongs in the realm of standup comedy.

3. Get Ready for Troubles with US State and Local Governments Over a year ago I wrote that public sector wages, benefits and pension plans would overwhelm the finances of many states and municipalities. This is now old news. The so-called stimulus package last year helped bail out the states. But this year with a Republican House and burgeoning Federal deficits there will be tremendous political resistance to further bailouts. The financial media has now caught up with this issue. Meredith Whitney, the only sell side equity analyst to have correctly called the subprime crisis, is raising warnings on this issue. There’s a lot of pain ahead on this and cuts in public sector wages, benefits and pensions will have to come but they won’t come easily. New York, California and Illinois in particular are three large states in very large fiscal trouble.

My question: Can the stock market do well when bombs are going off in the state and municipal sectors? Will stocks become a place of refuge or do we go back to the “everything goes down” mode of 2008. My best guess is that well capitalized, large cap, export oriented, technology oriented US companies will be seen as a place of refuge. As will gold. Stocks of banks that own large quantities of municipal bonds are another matter.

4. 2011 Looks to Be a Difficult Year for China – Chinese interest rates though still negative in real terms are going up, massive bank lending in 2009 and 2010 must have brought with it significant yet-to-be-revealed non-performing loans, the country has over invested in infrastructure projects and real estate, the currency is still undervalued, inflation is a real problem thanks to strong money growth, environmental problems are legion. The list goes on. Most analysts are debating whether China will have a hard or soft landing in 2001. Nobody knows the answer to this, especially for a country where statistics are sparse and unreliable and transparency is lacking. It is no accident that in renminbi terms the Shanghai A share market was down almost 17% in 2010. The market doesn’t like what it sees.

Longer term I remain very bullish on China. For the last few thousand years, China has gone through long cycles of increasing power, national unity and expansion, followed by slow decline and then national disintegration. And then the cycle repeats. With the ascent of Deng Xiaoping in the late 1970s and the disaster of the Cultural Revolution imprinted on all minds, the national disintegration phase ended. China is now in the up-phase of increasing power, national unity and expansion. I have no doubt that a nation of 1.3 billion hard working talented people with a religious craving for material improvement is a great long run place to put your money. I regard forecasts of China collapsing due to social unrest or regional problems as fundamentally at variance with the long run historical trend.

The US in the nineteenth century was the world’s rising economic power. But it wasn’t all smooth sailing. Occasional crises were experienced along the way such as the defaults of the states in the 1840s, the Civil War of 1860-65, the Panics of 1873 and 1893. Foreign investors from time to time lost their collective shirts as the US marched on to greatness. But the US emerged stronger after each crisis as economic and political imbalances were corrected. Crises correct imbalances and force the resolution of heretofore unsolvable political problems. For example, India’s early 1990s ditching of the so-called “License Raj” only came response to a foreign exchange crisis.

I am not wishing a crisis on China. But China in my opinion needs to make some tough decisions and these decisions will benefit investors in the long run. China is following what has been called the East Asia Model, i.e. a high degree of protectionism with all kinds of administrative and tariff restrictions on imports, an undervalued exchange rate, an over-emphasis on investment, an over-emphasis on exports, a massive interference in the markets, a predatory approach to foreign technology, an over-accumulation of dollar reserves and over-investment in designated favored industries. This fundamentally mercantilist model takes advantage of the international monetary system which allows countries to hold their currencies below equilibrium levels and the expense of employment in the United States.

The East Asia Model may have reached the end of its usefulness for China. It certainly has for Japan. The time to really load up on Chinese stocks will be when it appears the government has decided to turn away from this model. Whether the government will take the necessary decisions in a gradual, rational way or whether it needs to be forced to do so by a crisis remains to be seen.

In fact, Europe does not. The euro represents huge financial value added as compared with the bewildering smorgasbord of currencies that existed before. History, politics, technology and geography are all lined up in support of the euro. The euro represents a tremendous step forward in European integration. The Europeans spent a good part of the twentieth century killing one another. It’s an unpleasant experience they don’t want to repeat. At the same time telecommunications and transportation technology are bringing the already geographically contiguous European nations even closer together. Don’t underestimate the power of a fiber optic cable! The Germans will pay and pay to support the euro, however contrary to their self interest some of their actions may appear from time to time. And in my opinion, no countries will leave the euro. If you think Greece is having problems now with street demonstrations, just imagine if one day Greeks woke up to find their bank accounts were suddenly denominated in drachmas (draculas?) instead of euros.

Of course the euro does suffer from the same fault as all fiat currencies. Gold is still an investment alternative for euro area investors. But against the dollar the euro will play musical chairs. When Ireland, Greece, Portugal or Spain are in the headlines (Belgium and Italy?) the euro will decline against the dollar. When California, Illinois or New York take center stage, the dollar will down against the euro. I see plenty of opportunities for traders but no trend here.

6. Take a Look at India — India is an emerging market story in its own right. It’s the odd man out in the BRIC thesis. Brazil and Russia supply commodities to China and are part of the China story. To a large extent the fate of Brazil and Russia (and numerous other emerging markets) depends on how China does in 2011. India’s not a major part of this China picture although India-China trade has been growing.

India and China may be in Asia and have a lot of people coming off the countryside, but that’s where the similarity ends. China is homogeneous (92 % Han), relatively monolithic with one national language and with a government that is, in its own mercantilist way, pro-business. India on the other hand is a heterogeneous collection of peoples, cultures and languages. Indian technology firms are global and among the best in the world. The Indian business sector operates in English and compared to China is transparent and follows the rule of law. But from an economic/business viewpoint the bureaucratic, populist Indian government although democratic can be a major obstacle. It is often said that companies succeed in China because of the government while they succeed in India in spite of the government. Still longer term that could be a positive for India. Governments usually support losers and in fact create them by insulating companies from competition and offering subsidized access to capital which encourages low productivity. Examples of this abound in China. With the exception of some state owned firms, Indian companies are private and have to compete for capital and customers without any government coddling.

Indian stocks compared to other emerging markets are not cheap. But I think typical portfolios should have some Indian exposure. In addition, because the India/China stories are not so interwoven, India offers some advantages of diversification.

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Dr. Peter T Treadway is an independent consultant and money manager and Adjunct Professor in Asia. He is currently is principal of Historical Analytics, a consulting and investment management. He pens a monthly letter (The Dismal Optimist) for clients. He is also Chief Economist for C T RISKS, a new Hong Kong company that will assist Asian financial institutions with their risk management problems.

Dr. Treadway previously served as Chief Economist at Fannie Mae (1978-81), and prior to that, was an institutional equity analyst at Smith Barney (1985-98). He was ranked as “all star” analyst eleven times by Institutional Investor Magazine. Dr. Treadway also worked at The Board of Governors of the Federal Reserve. He holds a PhD in economics from the University of North Carolina at Chapel Hill, an MBA from New York University and a BA in English from Fordham University in New York.